Many market observers seem surprised that implied stock volatilities in 2017 have been at or near their lowest levels in a decade despite uncomfortable uncertainties across the global economy: the Trump administration’s fiscal and trade policy agenda, elections in France and the UK, China’s upcoming Party Congress, geopolitical hotspots smoldering. How is it that several major measures of implied volatility (including the CBOE Volatility Index (VIX), the Merrill Lynch Option Volatility Estimate (MOVE) Index and the volatility on 1-year/10-year implied swaptions) are pricing continued placid waters ahead?

One way to understand this phenomenon is to think of low implied volatility as limiting uncertainty to a defined range of possible outcomes. Here’s a simple corollary: Say an investor is uncertain about what to order for lunch – a hamburger or a salad. The outcome, whichever it is, will not cause increased volatility. What could cause volatility in that situation is a “wild card” outcome beyond the limited range of burger-versus-salad uncertainty: a case of food poisoning, for example, or a surprise celebrity sighting at the lunch counter. Whenever the possibility for such a wild card event has appeared in the global economy over the past several years, central banks have acted countercyclically (via prompt injections of liquidity) in an effort to maintain the same range of potential outcomes.

While realized volatilities (along with implied, or forward-looking, volatilities) are already low, they could go lower yet again. It’s true there are many things in the world that we are uncertain about today – elections, policy changes, and so on. For the most part, however, these are not unknown, wild card events, and most investors and observers expect that these events will not change the range markets are trading in, with central banks acting as needed to preserve the status quo. As each event passes, realized outcomes remove the uncertainty, so investors remove the risk premiums built into the market – resulting in a drop in implied volatility. Implied volatility will only go up when we break the range and/or when enough market participants believe that central banks’ reaction functions or ability to influence markets have changed. Right now we only have events that push us around a well-established set of ranges (albeit sloppily) and do not change our macro sense of well-being.

Volatility meets reality: investment implications

We have observed this phenomenon for nearly a full year now – and the market is pricing more of the same with the same confusion. Just because there are many uncertain events ahead of us does not mean there will be a break in the range or in realized volatility; this suggests investors may want to think twice before buying volatility indiscriminately. There are markets where volatility is well below historical averages, such as the U.S. equity market, and others where volatility is only slightly below historical averages, such as the U.S. rates market.

Investors should remember that uncertainty does not mean realized volatility and that there are reasons why market volatility has been so low.

For more insights into the range of potential policy pivots driving uncertainty in the global economy and testing markets over the next three to five years, please read PIMCO’s 2017 Secular Outlook, Pivot Points.”

READ HERE

William G. De Leon is PIMCO’s global head of portfolio risk management.

PIMCO Blog

Source: http://capitalisthq.com/dont-confuse-uncertainty-with-volatility/